Profit and cash
Profit is the positive difference between a firm's sale's revenue and its total costs of production. The fact that a company is profitable does not guarantee it will be solvent. A profitable company may run out of cash. Why?
It is often assumed that at the end of the year, a sum equal to the firm's profit, is in the bank account able to be used to pay bills or fund expansion. In reality, it is more likely that profits will be tied up in some other area of the firm and will be in some other form of asset rather than cash.
It is possible for a firm to be profitable, but also be short of cash because:
- Many sales are on credit. They will be counted in the firm's profits, but the cash may not appear for months.
- The firm may have invested heavily in capital items. The cost of these assets may impact heavily on the firm's cash position.
- The firm may have invested in stocks. The cash outflow occurs when they are bought.
- Some items are paid for in advance, but do not appear as a cost until much later.
In the 1980s, Body Shop was expanding rapidly through the use of franchising. Every new franchise required training, new equipment, marketing and supplying. Body Shop was very profitable, but suffered a cash flow/liquidity problem as much of its cash became tied up in new franchises.
Bowater Scott, a paper manufacturer was making heavy losses. It decided to sell some of its loss-making divisions. The sale resulted in Bowater Scott having a large pile of cash, despite its losses.
Cash is not the same as profit. A firm may be making losses, but is 'cash rich' or alternatively may be very profitable, but suffering from liquidity problems.
